The talk of the town is that Jay
Will outline the taper today
Inflation’s been mulish
And he has been foolish
-ly saying t’would soon go away
This outcome means Madame Lagarde
Remains as the final blowhard
Who claims that inflation
Is our ‘magination
Which might get her feathered and tarred
It’s Fed day today and the market discussion continues apace as to just what Chairman Powell and his FOMC acolytes are going to do this afternoon. The overwhelming majority view amongst the economics set is the Fed will outline its plans to taper QE purchases starting immediately. Expectations are for a reduction in purchases by $10 billion/month of Treasuries and $5 billion/month of Mortgage Backed Securities. Many analysts also believe the statement will leave wiggle room for the FOMC to adjust the pace as necessary depending on the unfolding economic conditions. Powell has been taking great pains in trying to separate the timing of reducing QE with the timing of raising interest rates, and I expect that will continue to be part of the discussion. Of course, the market is currently pricing in two 25bp rate hikes in 2022, essentially saying the Fed will finish the taper next June and hike rates immediately. This is clearly not Powell’s desired path, but the wisdom of crowds may just have it right. We shall see.
In addition to that part of the announcement, we are going to hear the Fed’s view on how inflation will evolve going forward, although at this point, I think even they have realized they cannot use the word transitory in their communications. Talk about devaluing the meaning of a word! What remains remarkable to me is the unwavering belief, at least the expressed unwavering belief, that while inflation may print high for a little while longer, it is due to settle back down to the 2% level going forward. I continue to ask myself, why is that the central bank view? And not just in the US, but in almost every developed nation. For instance, just moments ago Madame Lagarde was quoted as saying, “Medium-term inflation outlook remains subdued,” and “conditions for rate hike unlikely to be met next year.”
To date, there has certainly been no indication that global supply chains are working more smoothly than they were during the summer, and every indication things will get worse before they get better. The number of ships anchored off major ports continues to grow, the number of truck drivers continues to shrink and demand, courtesy of literally countless trillions of dollars of fiscal stimulus shows no sign of abating. Add to that the current environmental zeitgeist, which demonizes fossil fuels and seeks to prevent any investment in their production thus reducing supply into accelerating demand and it is easy to make the case that prices are likely to rise going forward, not fall.
There is a saying in economics that, ‘the cure for high prices is high prices.’ The idea is that higher prices will encourage increased supply thus driving prices back down. And historically, this has been true, especially in commodity markets. However, the unspoken adjunct to that saying is that policies do not exist to prevent increased supply and that the incentive of higher revenues is sufficient to encourage that new supply to be created. Alas, the world in which we find ourselves today is rife with policies that may have political support but are not economically sound. The current US energy policy mix preventing oil drilling in ANWR and offshore, as well as the cancellation of the Keystone Pipeline served only to reduce the potential supply of oil with no replacement strategy. If policy prevents new production, then no price is high enough to solve that problem, and therefore the ceiling on prices is much higher.
I focus on energy because it is a built-in component of everything that is produced and consumed, and while the Fed may ignore its price movement, manufacturers and service providers do not and will raise prices to cover those increased costs. The upshot here is that instead of high prices encouraging new supply, it appears increasingly likely that prices will have to rise high enough to destroy new, and existing, demand before markets can once again return to a semblance of balance. Given the fact that fiscal largesse has been extraordinary and household savings has exploded to unprecedented heights during the pandemic and remains well above pre-pandemic levels, it seems that demand is not going to diminish anytime soon. I fear that rising prices is a new feature of our lives, across all segments, and something we must learn to address going forward. While there is no reason to believe we are heading to a Weimar-style hyperinflation, do not be surprised if the “new normal” CPI is 3.5%-4.5% going forward. At the current time, there is simply nothing to indicate this problem will be addressed by the Fed although we are likely to see smaller, open economy central banks raise interest rates far more aggressively. As that process plays out, the dollar will almost certainly weaken, but we are still months away from that situation.
So, ahead of the FOMC statement and Powell presser this afternoon, here’s what’s been happening in markets. Despite record high closes in the US markets yesterday, Asia (Nikkei -0.4%, Hang Seng -0.3%, Shanghai -0.2%) did not follow through at all. Europe, too, sees no joy although only the FTSE 100 (-0.2%) has even moved on the day with other major markets essentially unchanged. US futures are also little changed at this time with everyone waiting for Jay.
Bond markets, on the other hand are continuing their recent rally with Treasury yields lower by 1.4bps and Europe (Bunds -1.5bps, OATs -2.0bps, Gilts -0.3bps) all rallying as well. Peripheral markets are doing even better as it seems the European view is turning toward the idea that the ECB will be outlining their new QE program in December with no capital key involved.
Commodity prices continue to give mixed signals with oil (WTI -2.4%) falling sharply, ostensibly on comments from President Biden admonishing OPEC+ to pump more oil. Will that really get them to do so? NatGas (-0.7%) is also a bit softer, but the metals complex is actually firmer with copper (+1.05%, aluminum +1.45%, and tin +1.8%) all showing strong gains. This as opposed to precious metals which are essentially unchanged on the day.
As to the dollar, it is hard to describe today. While versus the G10, it is generally weaker (CHF +0.4%, NZD +0.4%, SEK +0.3%) it has performed far better against EMG currencies (TRY -0.8%, RUB -0.7%, KRW -0.6%) although PLN (+0.4%) is having a good day. Unpacking all this the Swiss story seems to be premised on the idea that the market is testing the SNB to see if they can force more intervention while the kiwi story is a response to stronger jobs data overnight. Sweden seems to be benefitting from the emerging view of tighter policy from the Riksbank as they reduce QE. On the EMG side, Turkey’s inflation rate continues to be breathtakingly high (CPI 19.89%, PPI 46.31%!) and yet there is no indication the central bank will respond by tightening policy as that is against the view of President Erdogan. Oil’s decline is obviously driving the ruble lower, surprisingly not NOK, and KRW saw an increase in foreign equity sales and outflows thus weakening the won.
Ahead of the FOMC we see ADP Employment (exp 400K), ISM Services (62.0) and Factory Orders (0.1%), but while ADP will enter the conversation tomorrow, once we are past the Fed, I expect the morning session to be extremely quiet ahead of 2:00pm. From there, all bets are off, although my take is the level of hawkishness on the FOMC is edging higher. Perhaps there is some dollar strength to be seen post-Powell.
Good luck and stay safe